Why 2023 is different from 2007?

Since the beginning of the year, the US economy has maintained a downward trend in the general direction, but its resilience has exceeded market expectations. Looking back at the last endogenous recession, it may give us more enlightenment. In fact, before and after the end of the interest rate hike cycle from 2004 to 2006, the US stock market also continued to rise, and the US economy showed the characteristics of structural differentiation.

After the interest rate hike ended, there was once a great hope for a soft landing. Looking back at that time, we found that: first, the lagging effect of interest rate hikes needs sufficient time to show; second, the market often underestimates financial risks before the fact, believing that "this time is different." However, as the lagging effect of interest rate hikes on the economy becomes increasingly significant and the fragility of the financial system during periods of high interest rates intensifies, financial risks evolve beyond linear extrapolation, causing both the economy and assets to quickly reverse.

The interest rate hike cycle from 2004 to 2006 lasted for 25 months, with each meeting raising interest rates by 25 basis points, accumulating a total of 425 basis points. Looking back at the performance of the US economy and the US stock market from 2006 to 2008, it can generally be divided into three stages:

The first stage was in 2006, where various economic data showed inconsistent signals. Some leading indicators showed signs of weakness, but "hard" data, except for the real estate market, had not yet reflected it. Earnings supported the stock market's continued rise.

In the time, the S&P 500 rose by approximately 14% for the full year of 2006, mainly supported by earnings, which increased by about 16%, while the P/E ratio decreased by about 2%. Looking at the sectors, except for information technology and healthcare, all other sectors had annual increases of more than 10% (Chart 16). One of the mainstream views in the market at the time was that the US economy would experience a soft landing. Market expectations for earnings in the US stock market for 2007 were 5% in the third quarter of 2006, but were raised to 16% in the fourth quarter.

The second stage was from 2007 until the outbreak of the subprime crisis. During this time, various "hard" data began to show an economic slowdown, and significant structural differentiation began to emerge. Real estate, manufacturing, commodity production, and consumption all declined significantly, while the service industry remained resilient. The stock market diverged from the economy and continued to rise, with significant returns mainly supported by earnings in all sectors except for finance and discretionary consumption.

The third stage was in 2008, where the impact of the subprime crisis spread rapidly, causing the economy to rapidly decline and fall into a deep recession. One point worth emphasizing is that in fact, mortgage defaults had been escalating since early 2007. Looking back, the non-linear evolution of financial risks since the second half of 2007 has caused both the economy and assets to adjust rapidly in the short term. Of course, this change process may be difficult to predict in advance, and if there were any warnings, the real risk would not have occurred.

Overall, looking back at the changes in the economy and stock market from 2006 to 2008, one possible lesson is that even if it is difficult to predict the occurrence of a financial crisis, we cannot underestimate the possibility of tail risks during the interest rate hike process after a long period of asset appreciation and persistently low interest rates.

Even though the Federal Reserve had ended its interest rate hikes in mid-2006, and the economic outlook at the time was very optimistic, as the lagged effects of interest rate hikes on the economy and financial system began to emerge, the downward pressure on the economy and the fragility accumulated in the financial system eventually began to surface, and this exposure process even lasted for a year.

During this process, although economic data had periodic fluctuations and even several months of rebounds, the trend of slowing down remained unchanged. Although there may have been differences between the sectors supporting the stock market and those supporting economic data, leading to a divergence between the stock market and economic data, as the downward pressure on the economy intensified, the overall adjustment of earnings was eventually unavoidable.

There seem to be some similarities between the current situation and that of 2006-2008.

Firstly, the resilience of the economy has exceeded expectations, and there are increasing voices calling for a soft landing. In this regard, we need to learn from experience and avoid quickly shifting from pessimistic to optimistic expectations. It is not surprising that the economy rebounds within the overall trend of weakening.

Secondly, there is significant structural differentiation in the economy, with the service industry showing relatively stronger resilience. When the economic downturn transmitted to a decline in consumer purchasing power, although there was a lag, the weakening of the service industry seemed inevitable.

Thirdly, there is a divergence between the stock market and the overall trend of economic weakness.

If this time is different, it may lie in the changing resilience of households and corporate sectors, as well as the evolution of risks in the banking system and non-bank sectors.

Although the current US residential real estate market bubble is relatively low, and mortgage loan rating quality has reached a historical high, the household sector has deleveraged for a long time after the financial crisis, and with fiscal assistance during the pandemic, its balance sheet has been further strengthened. This means that the US economy may be more resilient than in 2007-2008, and if a recession occurs, the depth of the recession is expected to be milder.

However, potential risks hidden in other sectors cannot be ignored, such as the corporate sector and non-bank sector.

Firstly, the fragility of the corporate sector may be higher than in 2007. In 2007, when the market generally believed that default problems were mostly limited to the real estate sector, MBS was overlooked as an important collateral and was the cornerstone of the financial system at that time. At present, bank turmoil may still ferment, but it may not trigger a systemic financial crisis. The real financial crack may be hidden in the non-bank sector.

After the financial crisis, the banking system was subject to strengthened regulation, but the non-bank sector expanded significantly. The "US Treasury-repurchase" liquidity derivative model became increasingly important.

Correspondingly, US Treasuries have also become the cornerstone of the global financial system, especially the non-bank system. The "US Treasury-repurchase" mechanism appears to have operated stably under a long-term low-interest rate environment after the financial crisis, but financial leverage and even financial idling have exacerbated financial fragility and created a low-interest rate dependency.

All in all, we do not believe that the current situation will repeat the mistakes of 2007, but need to be more cautious about the short-term resilience of data. We believe that the US economy does have unexpected resilience, but under the dual pressure of the fastest monetary tightening in 40 years and supply constraints, the risk of "stagflation-style" atypical recession still exists. We should not ignore the possibility of non-linear evolution of economic downturn pressures and financial risks.

If there are risks brewing in the future, one "different" point worth noting this time is that the household sector's balance sheet is relatively stable, and the systemic risk in the housing market is low. Combined with possible long-term supply constraints, core inflation may have resilience, and there may be resistance to a sharp decline.

For controlling inflation, raising interest rates is more effective than reducing balance sheets, while for stabilizing finance, QE is more fundamental than lowering interest rates. In the past year, when the Fed, as the "last market maker," no longer provided liquidity support for US Treasuries, the cornerstone of the financial system became unstable, leading to frequent global financial risk events. When systemic financial risks are approaching, it is not ruled out that the Fed may restart QE while maintaining high interest rates.

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